As has been regulary diaried on this site by me or others, world politics and diplomacy are increasingly been determined by a global quest for oil resources, which are widely, if not very publicly, understood to be getting scarcer, or at the very least more exepensive, and in any case strategic.
Many diarists have noted the various efforts by China to establish new ties with oil producing countries in South America, Africa or the Persian Gulf. The tense relationship between Chavez's Venezuela and the Bush White House have been outlined. The question of whether there is oil in any country in the headlines at any times comes up regularly (if only to be debunked - but the simple fact that the question is asked is relevant).
I have been trying to put together these various strands in a coherent whole to explain the diplomacy of various countries and to try to make sense of them.
To start with, I am revisiting a post I wrote about a year ago, which provides some of the basics to understand the above: what does it mean to "control" oil? In future episodes, I'll look at the policies of China and others in that respect.
1. physical control
As the most basic level, you control the oil if you are in control of the physical good; You have it, you can use it or sell it. Naturally, control of the producing assets is more important ; this is shared between (directly) whoever owns the assets and (indirectly) whoever ensures that nobody else can own the asset - whether a functioning legal regime or brute military force.
Another aspect of this question, which may or may not be relevant for different oil assets, is the control of the transport infrastructure. Oil can be transported by pipeline (and will always be, at least for the very first steps from the oil well) or by boat (ocean faring tankers). If you have a way to block in any way the flow of oil to the market, whether because you own the pipeline, the port facilities or the boats or because you control the territory through which the pipelines or the boats (port, shipping lanes) go, you control the oil flow and are a player in the game.
In Nigeria, people get access to the pipelines and try to siphon off oil (and sometimes blow themselves off)
In Russia, in the early nineties, mafia groups would take physical control by force of railway or port infrastructure and "tax" oil exporters in the most basic way, by taking a share of the cargo.
Persian Gulf oil is vulnerable to any disruption to shipping within the Gulf or at the Hormuz straits.
Trade unions in oil producing countries can disrupt production and thus are players (see in Venezuela in 2003 or more recently in Norway).
Iraqi production is subject to the availability of the pipelines to export it out, which are targeted by the insurgency.
Caspian oil is such a complicated - and fascinating - subject because it is a closed sea with no access to international markets and any investment project must solve the export issues, which means dealing with at least two countries with some degree of control over the project (one where the production takes place and at least one transit country).
2. legal control
Physical control enforced by military or police means usually translates into - or is legitimized by sovereignty over the territory where the oil or oil asset is located. More generally, it means that the oil resource is subject to the internationally recognised right of this country to run its own affairs as it sees fit, and thus that its judicial system and laws apply. The authorities of the country have the legitimate authority to decide if and how this asset will be exploited, and the police/military and/or judiciary power to enforce such regulation.
Many countries (but not the US) have decided that underground resources belong to the country. Many have a national oil company (NOC) that will be the sole producer of oil and whose income goes directly into the public budget. Others will allow other entities to develop assets and produce oil, under predefined ownership and tax regimes, but subject ultimately to the country's authorities, usually through a NOC or oil regulatory body which will have predefined roles in every producing asset (majority or minority ownership, rights to a portion of production, responsibility for sale and marketing, etc...).
Transportation assets are usually subject to ad hoc regulation.
Monopoly producer: Most of OPEC (Saudi Arabia, Venezuela, etc..), Mexico
NOC with majority ownership: Nigeria
NOC with minority ownership: Azerbaijan, Angola, Indonesia, Malaysia
Production rights without ownership: Egypt, Azerbaijan, Kazakhstan, Angola
Some countries have various schemes in place.
Many of the countries in the top categories are experimenting with schemes to allow some foreign investment while keeping "control/ownership" of the assets.
The distinction between physical and legal control is especially important in an investment context. In order to produce, you first need (large) investments. these will come only if investors are comfortable with the future oil flows that will come their way to repay such investment, and the timescale for such investments is usually 10 years or more. If you invest, you want to be dealing with someone who has the authority to guarantee that these flows will not be impaired.
Physical control of the flows is obviously necessary, but is clearly insufficient: legitimacy matters more. If you deal with a stable but rogue power, what will protect your investment from the entity wielding it? What will protect you from claims brought by others (such a refugees from that "power") in Western courts (for instance under the Alien Torts Act?) that the oil is not really yours?
The absence of a functioning state will usually mean in practice that the oil belongs to whoever can actually get his hands on it or the production assets, but it means little more than pillaging. No investment will take place.
Iraq today is an interesting case study. Oil companies would not invest initially while the US forces were there because there was no legitimate entity responsible for the long term flow of the oil from Iraq (the long term legal status of the oil assets to be purchased/built was unclear). Now there is a legitimate power in place formally, but it lacks real "physical power and is unable to ensure basic security. Thus, an even simpler reason not to invest for outsiders.
3. operational control
Having physical and legal control of the oil reserves is not enough if you do not have the technical capacity to actually extract this oil and bring it to market. If the infrastructure exists, you can live off it for a while, and this is not an issue (see the Russian oil sector in the early 90s, when no investment took place). If the reserves are easily accessible, it is also possible that the competences required are not so difficult to find locally or to buy on the international market. But this is increasingly less and less the case, as the more easily accessible reserves have been found and produced and increasingly distant or difficult reservoirs are being tapped. In that case, the more frequent, highly specialised (and expensive) technology and expertise is required, and this can be provided mostly by the Western oil majors. It is a combination of technology management (sophisticated seismic exploration, deep-water production, horizontal drilling, reservoir assessment and management) and project management: oil fields are amazingly complex mutli-billion-dollar projects, which require the ability to coordinate many parties in an elaborate ballet, with very tough logistical constraints (lack of access, lack of infrastructure, hostile conditions for personnel, etc...) and a deft sensitivity to the local environment. (Not to mention the management of the financial aspects, PR, and politics locally and in the home country).
The entities which are able to run big oil projects will effectively take over operational control from the local authorities which are otherwise unable to exploit their underground resources. This creates a co-dependency, which brings us to the relationship between local authorities and oil companies.
4. regulatory control
We have now reached a more sophisticated point in our analysis whereby various entities have some degree of control over the oil by virtue of controlling some element of the oil chain: the territory of production or transportation, the technology or the financing. How do all these parties interact and reach an agreement? Who can actually be said to have "control"?
The question in normal times (i.e. outside of war) actually is: who gets the "rent"? The rent is the difference between the actual production costs, including the costs to bring the oil to the market and the price fetched by that oil on the international market (depending on its quality and its point of entry into the market). This rent can be quite high, as all-in oil production prices usually are in the 2-15 $/bbl range. Until recently, a price of 15-20$ was used by the big oil companies to test whether an investment would be worth it or not on a long term basis.
In the past (until the second part of the XXth century), most of the rent was captured by the oil companies. This reflected US practice, and as the US accounted for the biggest portion of world oil production, it was also used in the rest of the world (most of it still being colonies, the Western powers also did not worry too much about the locals). After WWII, and following major discoveries in the Persian Gulf area, the oil industry internationalised a lot more, at the same time as the decolonisation movement took place. This eventually led to a new sharing of the rent. For a time, it was a simple formula: 50/50 between the oil company and the host country. Eventually (and despite valiant efforts - or consipiracies - by the oil companies and their home governments (the "seven sisters"; US, UK and France), this moved in favor of the host countries, whether through more favorable agreements (concessions, PSAs - production sharing agreements, joint ventures) or outright nationalisation.
Today, it is accepted that the host country will capture the major part of the "rent" (up to 90%). Oil companies accept to have the perspective of "only" a decent return if production goes as expected, and a small part of the upside if things are better. As they will do most of the initial investment, they usually get more of what's available if it is less than expected. In return, they get access to a recurrent flow of oil and can "book" the reserves in their accounts.
In the context of the PSAs, which is now the main instrument in the international oil business, the oil produced is separated into "cost oil" and "profit oil" according to more or less complex formulas.
- Cost oil is used to repay the oil companies for their investment: operating costs, some taxes, and reimbursement of the initial capital costs and associated financial costs (banks interest and/or a predetermined rate of return). What costs are "recoverable", what interest rates are used to roll over costs not yet reimbursed and what tax rates are applicable are negotiated on a case by case basis.
- Profit oil is, as its name indicates, pure profit after operating costs have been deducted. It is shared between the host country and the investors according to complex formulas.
Initial production will usually be mostly used as "cost oil", in order to repay the investment as quickly as possible. The host country will get a minimum level of revenues through the pre-agreed level of taxes and in some cases a minimum proportion of "profit oil" from the start (which may vary depending on the actual production levels vs expected ones). After a few years, cost oil will phase out and most of the production will become "profit oil", which is then shared mostly for the benefit of the host country.
Of course, the sharing formulas depend on oil price levels, actual production levels and plans for future investment, so they are different in each case. They must also take into account the full production costs of the asset and its complexity (both technological and in terms of the number of "interested parties").
A common practice in the industry is to separate each item of the production and transportation chain into stand alone investments: the production platform and associated facilities, the pipeline, any other independent facilities which may needed. (This is even more characteristic in the natural gas industry).
Each entity is structured so as to be profitable on its own. For instance, the transportation tariff for use of a pipeline will be set so as to cover the cost of its construction plus cost of capital and a small return. That tariff will be paid by the upstream (production) entity which uses it to export its production, and this entity will be entitled to include that tariff into its "cost oil" calculations. It will also paid as a priority by the upstream facilities (possibly even before local taxes, which makes sense if you consider that there are no revenues until the oil reaches the market, for which the pipeline is needed). Such tariff is defined contractually between the upstream company and the pipeline company and usually reflects the fact that such "intermediate" entities in the oil chain take only a limited amount of risk (for which they get a very predictable revenue stream, which makes is easier to keep such entities transparent -to justify their inclusion into "cost oil"- and to finance them externally). A frequent principle is that they get paid as long as the required industrial (in that case transportation) capacity is available, whether it is used or not.
Easily identified portions of large projects can thus be `spun off" and financed on a stand-alone basis. This also allows for subcontracting of the work and management - and risk - of a very large project in smaller pieces (even if the owners are the same all along the chain), by allocating responsibility for well-identified tasks to other entities.
As regards the issue of control, such big contracts are usually done within an extraordinarily heavy contractual framework, involving dozens of external advisors on both sides: lawyers, accountants, tax specialists, independent engineers and other specialised consultants, and bankers. These contractual framework usually define the regulatory framework which will apply to the project for its duration, including things like technical standards and norms, health and security regulations, environmental rules, social and working conditions, local content, etc... This means that the host government has a lot a control of the project within the framework of such contracts. It can impose its standards and rules and enforce them. Local or international arbitration can be defined to settle disputes, but a lot will be left to bilateral negotiation.
(An important point to make here is that on the oil company side, you usually have a consortium of several companies, as they usually do not like to be on their own in complex or difficult projects, especially in tough countries. There usually is a leader amongst them, the "operator", who will be in charge of running the operations on the technical side as well as managing the relations with the host country. The others will be more or less active depending on the contractual framework between them, their own inclination, and the history of the project. Some of the super-majors do not like to be subordinate to others, but it does happen and it makes for complex project management...).
Countries always have the "atomic weapon" against oil companies of taking (or taxing) the project away from them. They also have ways to put pressure on the operator by imposing more or less stringent supervision of the project, imposing deadlines, local content requirements, etc...The contractual framework is supposed to regulate all these issues, but in practice, especially in countries where the legal system is not independent of the political power, it is a tug-of-war and it depends a lot on the more global framework and this simple question: who needs the project (and its revenues) the most? Who can afford the least to wait one more year before production increases as expected. The oil companies' leverage is that they have the financial and technical capacity to invest. But they have shareholders to satisfy, which means they need to book reserves, to have revenues and make profits. The host countries have the power to slow or kill a project, but they are often cash-starved and need the revenues (not to mention that individuals within their power structure expect to benefit personally from the project). Some countries have better bureaucracies, are less desperate or prouder and can get better terms from the oil companies. Some also have a better reputation of sticking to the agreements they enter, so can get better terms because the oil companies accept them in exchange for their stability.
The geopolitical context also plays a role, and especially the nature of their relationship with the US (as the biggest importer, the home of several of the big oil majors and the "world cop") and a few other countries (France and UK for their majors and their residual international presence, Japan and China as major importers, Russia and China in their areas of influence). Host countries, if they are smart, can play on these relationships to get better terms.
So, you have control:
- because you can kill or slow a project (political oversight, regulatory authority, NGOS/hostile local communities, terrorists). Those that can kill a project only have "control" in the sense that they can block the project, but may have less control over a functioning project (if it functions precisely because their claims have been satisfied or their capacity to block it has been neutralised).
- because you are the only one able to make it happen and/or pay for it (oil majors). This is a very real source of control;
- because you are part of the chain required to make it happen, and can mess up the economics for others (anybody involved: workers/unions, transit country, financiers, etc...). This control is compensated by the fact that all the links in the chain make money only if the oil flows and all ultimately have an interest in getting the oil moving.
Next: who has control over oil
prices